Equities Experience Healthy Pullback

The nearly 4% pullback registered last week by the S&P 500 was long overdue. The magnitude of the decline and overzealous investor sentiment prior to it raises the odds of additional weakness or at least sideways trading in the coming weeks or longer. But we feel the weight of the evidence remains bullish. Global economic growth is good, earnings are growing, and despite the move in interest rates, yields remain low. For this reason, we would patiently accumulate stocks during periods of weakness in the weeks ahead.

Rising interest rates and wages weigh on sentiment due to the potential negative impact on corporate profits and stock valuations. Since year-end, interest rates have trended higher as the 10-year Treasury yield moved from 2.4% to 2.84%. The equity market ignored the move from 2.4% at year end to 2.66% by 1/26. However, the move from 2.66% to 2.84% in the past five trading days was a bit “too much too fast” for investors. The strong jobs report on Friday and, more importantly, the above-consensus 2.9% 12-month gain in hourly earnings (vs. 2.7% in December) stoked fears of inflation.

We concur with the market’s anxiousness over the recent rise in interest rates as well as the fear of potential rising inflation due to higher wages. As a reminder, higher interest rates and wages eat into corporate profits. With valuations for equities at elevated levels, any headwind to corporate profits would be a problem. Also, higher inflation and interest rates typically cause investors to feel less compelled to pay a premium valuation for stocks, hence the current lofty price-to-earnings ratio would likely contract. However, at 2.9% 12-month wage growth and 2.84% 10-year yields, we think investors are overreacting … for now. We think more evidence of a problematic rise in interest rates and wages will be needed before the market merits a meaningful setback (>10%) with all other market-influencing factors so positive.

Investing involves risk, and investors may incur a profit or a loss. All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates, Inc. and are subject to change. Past performance is not an indication of future results and there is no assurance that any of the forecasts mentioned will occur. The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made in this index. The performance noted does not include fees or charges, which would reduce an investor's returns.

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